If you want to learn the art of deal-making on a very high level, you may consider reading "Merger Masters: Tales of Arbitrage" by Kate Welling and Mario Gabelli.
I just finished this new book, and it's outstanding. I highly recommend it to all of you.
Reading the book gave me some pause, as it occurred to me just how much the arcane art of risk arbitrage dictates the way I look at markets and companies.
I have traded arbitrage almost from the start of my investing career. Some of my biggest success stories were from liquidation arbitrage situations where the value of the assets appreciated during the liquidation phase, and we collected far more than initially anticipated.
But the value of doing merger deals is not just the money that we can make, but the information and lessons we can learn from studying the deal markets on a daily basis.
Analyzing merger deals and evaluating the likelihood that all the regulatory hurdles, shareholder approvals, and financing issues can be overcome to allow quick closing on profitable terms is more of an education than any MBA program in the country if making money in the stock market is your ultimate goal.
So, let's take a more detailed look today at some of the things you can learn from studying arbitrage...
Arbitrage 101: A Beginner's Guide to the Arcane Art of Deal Making
Here's the first thing you need to know about arbitrage...
There are two major players in the deal market.
The first set of major players is the strategic buyers. These are companies trying to grow assets and increase their share price by buying up smaller companies. Most of strategic buyers fail at this, as shown not only in a study by consulting firm KPMG, but by my three decades of merger and market watching.
Most mergers never live up to the lofty goals outlined in the proxy filings. In spite of good intentions and even lots of hard work to make deals work, the KPMG study found that as much as 70% of all mergers failed to increase shareholder value after the deal closed. About a third of the post-merger companies actually destroyed shareholder value.
The second set of major players is the financial buyers. These are the private equity firms, merchant banks, and takeover artists. They tend to buy companies with borrowed money, improve the bottom line, dress them up real pretty, and sell them in a few years for several multiples of what they paid.
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Most of the financial buyers that last more than a few years in the merger game are really very good at the art of the deal. They make tons of money doing deals because they tend to be bargain buyers and they have no emotional attachment to the company at all. They are much more aggressive about cutting costs and getting rid of unneeded personnel and property.
So now that we've addressed the major players in arbitrage, let's address the how to...
And that involves us.
To successfully practice liquidation arbitrage, you need an exact knowledge of the value of corporate assets and the patience of an ancient elephant, but the returns run from "Not too shabby," all the way up to "Whoa Nelly, that was really (expletive deleted) fantastic."
When you engage in liquidation deals, you learn how to spot companies that are trading for less than their actual liquidation values. It takes hours, or sometimes even days, to calculate the value of one of these announced liquidations.
You become good at figuring out the resale value of the property, equipment, securities, and other assets that the company owned. You also get pretty good at credit analysis because you only want to own those companies that can keep their bills paid until the liquidation is done profitably.
You'll also learn to closely follow deal multiples. Mergers are usually priced in some variant of the Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) multiple. If I see that healthcare deals are getting done at a multiple of 11, and I can find a high-quality healthcare firm with a strong balance sheet and solid cash flow, it's probably a bargain – with a good chance it gathers attention from potential buyers sooner rather than later.
But mind you, it's not just the big institutional players that can engage in arbitrage – retail investors can participate as well.
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Small banks are one way to do this. And small bank arbitrage of announced deals has been incredibly lucrative.
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Retail holders of small banks tend to sell on the announcing of a bid, and there simply are very few institutions willing to play the risk arbitrage game for the comparatively small amounts of money involved. I am not managing billions of dollars, so picking up deals that involve just tens of thousands, or even just thousands of dollars, is usually worth my time if the spread is big enough.
Best of All, Studying Arbitrage Teaches Us About the Markets
Studying merger and acquisitions activity can give us solid clues about what is going on in the markets and the economy.
If money is loose and it's easy to close deals, then it's probably time to step away from the table.
An easy lesson here is that if the deal market is primarily financial buyers and average deal multiples are pretty low, it's an excellent time to buy stocks. This measure can be applied equally to the broad market as well as individual sectors that are attracting unusual amounts of activity from financial buyers.
When it's almost impossible to get an M&A loan done and the only buyers in sight look a lot like me, it's probably time to jump into stocks in a big way.
The lesson here is that if deals are getting done at high multiples, then it's usually a good time to step aside. Currently, we are seeing P/E firms sell $1 of old assets for every $2 they buy. They also have lots of dry powder they are finding it hard to spend because deal multiples are around 11 right now. In comparison, the average deal multiple in 2009 as the markets bottomed was under 7.
When deals are routinely getting done at less than a 7 EBITDA multiple, corporations are cheap. At such times, strategic buyers are usually handicapped because their stock is their chief currency and has been going down, so no one wants it.
We find similar information in arbitrage spreads. When spreads are tight and profit margins for risk arbs are at razor-thin levels, we are deep into the greed part of the cycle. When spreads are wide enough to turn double-digit profits on every deal, then fear has the market in its icy grip.
As the Oracle of Omaha has suggested, the key to long-term survival and success in the stock market is to be fearful when others are greedy and greedy when others are fearful.
All in all, studying M&A transactions and merger arbitrage markets will make you a smarter, better investor.
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The post Spend 100K on an MBA. Or Make Millions by Learning This Arcane Art appeared first on Max Wealth.
About the Author
Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.